The Role of Private Equity Firms in the U.S. Economy

MS. DIANE REHM

10:06:55
Thanks for joining us. I'm Diane Rehm. Presidential candidate Mitt Romney has touted his record as a jobs creator, but Romney's role as head of a private equity firm has been questioned most strongly by his Republican rivals. They painted a picture of Romney as a corporate raider and asset stripper. The entire private equity industry has come under closer scrutiny. Today, we talk about the role of private equity in the U.S. economy.

MS. DIANE REHM

10:07:38
Joining me here in the studio: Eileen Appelbaum of the Center for Economic and Policy Research and Megan McArdle of the Atlantic magazine. Joining us from a studio in Chicago, Steven Kaplan of the University of Chicago Booth School of Business. I hope you'll join us, 800-433-8850. Send us your email to drshow@wamu.org. Join us on Facebook or Twitter. And good morning to all of you.

MS. EILEEN APPELBAUM

10:08:24
Good morning.

MS. MEGAN MCARDLE

10:08:24
Good morning.

PROF. STEVEN KAPLAN

10:08:26
Good morning.

REHM

10:08:27
Megan McArdle, let me start with you. Explain what private equity actually is and how it's used.

MCARDLE

10:08:37
Well, there's actually -- there's two main kinds of private equity to simplify. And, actually, since Prof. Kaplan taught at my old business school, I sort of take my heart in my hand here if I get it wrong. But you basically have, on the one hand, venture capital, which is what a lot of us think about when we think about private equity. It's where you go, you find a company that's in a very early stage of development. You pour money into it to give them the capital to build up their business to a profitable stage, and then you exit usually by taking the company public or selling it to another company.

MCARDLE

10:09:12
Then you have, on the other hand -- and this is often what more people call actual private equity. It's the side where you buy a company. You take it off in private. And so you actually buy out the shareholders, take it private. It's often done with a great deal of debt. And then you usually do some sort of turnaround. You may sell assets. You change the cash flows. And in other ways, you add value for the people who are now the owners of the company and then often, again, exit by taking it public when it's turned around or by selling it to another company.

KAPLAN

10:09:55
Excuse me.

REHM

10:09:56
Sure.

KAPLAN

10:09:56
There's a third kind of private equity that's somewhere in between that's called growth equity. And that's important to mention 'cause Bain Capital actually did a lot of growth equity deals, and that's where -- it's a company that's operating. It's had the venture capital. It's doing well, but it needs extra capital in order to grow even more.

REHM

10:10:16
Prof. Kaplan, who are private equity firms? Are they groups of people who pool their money to come in to, as Megan says, buy up a failing firm or buy up a private company that they feel they can change?

KAPLAN

10:10:38
So the private equity firms start off -- you have to ask where they get their money. And they get money from pension funds and endowments. More than half of their money comes from pension funds and endowments. And it turns out the NPR Foundation has 10 percent of its endowment in private equity firms. So, Diane, you are an investor in private equity effectively. Then the private equity firms get this money, and they have -- they're called the general partners.

KAPLAN

10:11:08
And those are the Bain Capitals, the KKRs, the Carlyles, and they take this money. And then they use it to, as Megan said, buy companies or invest in companies that are growing.

REHM

10:11:23
So -- pardon me -- so, Megan, there are private equity firms that go for positive growth, and there are those that are destructive?

MCARDLE

10:11:37
Well, you know, and there's a lot of different ways to be destructive. And one of them is just to be bad at what you do. I mean, you can go in and do a bad deal where you haven't really assessed things correctly and you'd accidentally destroy a company that you didn't mean to. And that's sort of the risk that any financial market runs. And then there's the question of, are you taking firms that were basically -- they weren't maybe performing stellarly, but they were basically kind of running along, generating some growth for their shareholders, generating some income for their employees and so forth?

MCARDLE

10:12:09
And then you load that company down with debt. You increase the risk of that company. It can do much better when you do these deals, but it can also fail now. It can end up in bankruptcy. It can strip a lot of value from, say, pension holders and other people who had prior claims on the firm. And so, you know, there's an open question, which kind of deal did, for example, Mitt Romney do? And that's really, I think, what the core of the debate has been over the last few days about this.

REHM

10:12:39
Steven Kaplan, what about taxes? Do these private equity firms pay a fair share of taxes?

KAPLAN

10:12:50
So the taxes that they pay are, you know, two, they have received money in fees from their investors, which is ordinary income, and then they also receive money when they sell a company and make money. They tend to get 20 percent of the profits. And that 20 percent profit share is taxed as a capital gain. And there are arguments, you know, both ways as to whether those profits should be taxed as capital gains or ordinary income.

KAPLAN

10:13:25
I happen to think that capital gains make sense because if you try to change it, they would figure out ways around it because the profits, in effect, are equity investments. And as long as equity investments are taxed as capital gains, I think the private equity firms will be able to get that treatment.

REHM

10:13:46
Eileen Appelbaum, you have some problems with the way the private equity industry works.

APPELBAUM

10:13:55
Well, I just want to begin by saying that private equity is a -- it has a mixed record. I'm -- my biggest problem with them is that they are part of the unregulated shadow banking system in this country. And it's not that I think that they should not exist. My question, really -- and I'm really glad that you have this program because I think what we all have to think about is whether, in fact, we want these to be completely unregulated pools of capital that are being invested as they are. So do we want limits on leverage, for example?

APPELBAUM

10:14:30
Do we want to think about how debt is treated compared to how equity is treated in our tax laws? There are a lot of issues there that we might want to think about. But I did want to add something on the private equity model as it's been described. One of the things that most people don't really understand is that when a private equity company buys -- a private equity firms buys a company, as Megan has said, they use a lot of debt. But the private equity company is not responsible for paying back that debt. The debt is the responsibility of the company that they bought.

APPELBAUM

10:15:06
It's really a strange situation for most people to wrap their minds around. So Sun Capital...

REHM

10:15:13
Give me an example.

APPELBAUM

10:15:14
I'm about to. Sun Capital buys Friendly's ice cream, the iconic ice cream chain. They put up a small amount of equity, and they borrow in order to buy the ice cream chain. But it is Friendly's that is responsible for paying back the debt. And that has to...

REHM

10:15:34
How can that be?

APPELBAUM

10:15:34
Maybe Steve Kaplan can explain how that can be, but that is how it is.

REHM

10:15:40
That's how it is.

APPELBAUM

10:15:41
That's how it is and...

REHM

10:15:41
Steve Kaplan.

KAPLAN

10:15:41
Well, they're buying companies. It's like when you buy a building, or a company buys a building, the -- well, this is -- that's not the good example. The example is, when you invest in a company, you buy stock in the company on the stock market. You're buying stock in that company. And if the company fails, they can't come to you and ask you to pay the debt because you invested in the equity. And that's how our corporate structure is set up, and that's what they're doing. They're investing in equity companies.

APPELBAUM

10:16:18
So it is very strange, don't you think? I mean, I can understand that it's...

KAPLAN

10:16:21
No, it's limited liability. It's something that's gone back to the 1800s.

APPELBAUM

10:16:24
OK. So let me give an example of how this actually works in retail. Retail is a sector where private equity is very active. I think it's the main place that most people are going to run into it. So just to give you a few examples of places you have probably been that are owned by private equity: BJ's Wholesale Club, American Tire, Baha Fresh Mexican, Bausch & Lomb, Brookstone, California Pizza Kitchen, Chili's, J. Crew, Petco, Valley City department store -- Value City department store. So these are all companies that are owned by...

KAPLAN

10:16:59
Burger King, Dunkin' brands.

APPELBAUM

10:17:02
Yes, many companies owned by private equity.

REHM

10:17:03
But (word?)...

APPELBAUM

10:17:05
And so what happens is these businesses traditionally had low amounts of debt and owned their own real estate because these are cyclical businesses. The thing about retail and restaurants is you know they're in favor, they're out of favor, and they have to be able to survive that. Private equity comes in and turns that model on its head. So they put a little bit of equity in. They buy the company with lots of debt. The department stores are now required to somehow manage that debt.

APPELBAUM

10:17:34
And what they do is they divide the company into an operating company, which will run the stores, and a property company, which will own the real estate. And, now, these stores no longer own the real estate. They have to pay rent to the property company. In the case of Mervyns, for example, a mid-tier department store chain in the west, they ended -- they took the property company, held it for a year, so they got the capital gains, and then sold. The private equity owners sold the property company to a real estate investment trust. Mervyns is now paying rent. It got nothing out of it.

APPELBAUM

10:18:08
Its assets are sold out from under it. And it hits any kind of hard times at all, and you can imagine that it's not going to be able to manage.

REHM

10:18:18
Eileen Appelbaum, she's senior economist at the Center for Economic and Policy Research. She has a book coming out titled "Private Equity at Work." When we come back, I want to find out just how many of these companies go bankrupt as opposed to other non-equity-invaded companies. Stay with us.

REHM

10:20:05
And welcome back. We're talking about private equity firms. The leading candidate in the Republican race for the presidential nominee, Mitt Romney, has touted his record as a member of a private equity firm, Bain. But he has been questioned strongly by his Republican rivals. And here in the studio, as we talk about how these private equity firms operate, what they achieve, how they contribute or not to the overall economy, here in studio, Megan McArdle of the Atlantic magazine. She covers business and economics.

REHM

10:20:59
Eileen Appelbaum is at the Center for Economic and Policy Research. And, joining us from the University of Chicago Booth School of Business, Steven Kaplan. I do look forward to hearing your questions, comments, 800-433-8850. Eileen, just before the break, we were talking a little about how these firms operate. How many of the companies that the private equity firms invest in go bankrupt?

APPELBAUM

10:21:39
Well, there was a major study by Per Stromberg published in 2008. They found that they are twice as likely as publicly traded companies to go bankrupt.

REHM

10:21:50
Now, why would that be?

APPELBAUM

10:21:51
Well, one of the things that happens with high debt is high debt provides -- it magnifies the returns to private equity when it's successful, but it also increases the risk to the companies that have to repay the debt. So higher debt, you would expect to have higher risk. I just want to say, though, what he found is that, in his sample, about 7 percent of the companies owned by private equity went bankrupt.

APPELBAUM

10:22:17
I don't want to exaggerate the problem, but the point is that it's not a huge percentage when you say 7 percent. But on the other hand, that can be quite a few companies, quite a few jobs, and it is twice as high as the rate for other companies.

REHM

10:22:31
But what happens to the investors when the companies go bankrupt?

APPELBAUM

10:22:37
That's a very good question.

KAPLAN

10:22:38
They lose all their money, and that's...

APPELBAUM

10:22:40
Well, let...

REHM

10:22:41
All right. Steve, let her finish.

KAPLAN

10:22:41
That's what happens. Go ahead.

APPELBAUM

10:22:44
They can -- they don't lose all their money. They -- most that they can lose is what they have put up at risk, what they have invested. However, one of the things that companies do, which, I think, many people are critical of -- I don't know whether Steve is or not -- and that is, along the way, after they've loaded the company with debt, they can now go out and sell junk bonds, further debt on the company, and use that money to pay themselves what are called recapitalization dividends. So they often have taken their money out before the company ever went bankrupt.

APPELBAUM

10:23:16
Or in the case of Mervyns, which went bankrupt, once they sold the property company, they were able to pay off what they have borrowed, pay themselves back all of the equity they have put into it, already make a profit, and so it did not matter whether Mervyns went bankrupt or not. The private equity partners in that situation had no problem. Now, there are other examples where they, in fact, do lose their equity investment.

REHM

10:23:42
Steven, do you want to add to that?

KAPLAN

10:23:45
So let me give sort of the overall data, which Eileen has given you some. And Per Stromberg is a co-author and good friend of mine, and he finds the 7 percent bankruptcy rate, which is actually remarkably low, given that these are mature companies and have taken on leverage. Now, what Eileen doesn't say is that the returns to the private equity investors, which, as I mentioned, go to pension funds and endowments, including NPR. Those returns have been 27 percent better than what you would've gotten investing in public stocks.

KAPLAN

10:24:20
Meaning, every dollar you put in returns 27 percent more than if you put it in the public market. That's a lot of benefit to go around. And, of course, people who are beneficiaries of the pension funds include a lot of teachers, a lot of union workers, just a lot of people in general. Now, the leverage levels that Eileen mentioned are actually quite a bit lower today than they were in the '80s and '90s. Typically now, when companies are bought, the private equity investors put in 30 or 40 percent equity.

KAPLAN

10:24:56
So, unlike a mortgage when you buy a house, where maybe you put up 10 or 20 percent equity and borrow 80 or 90 percent, in these transactions now, it's really 60 or 70 percent debt and 30 or 40 percent equity, which is quite a bit. And there were a lot of people who were saying, as we went into the financial crisis, that many of the buyouts would go bankrupt because they were highly leveraged. And it turned out the evidence is very relatively few went bankrupt and actually not all that different from other public companies in this horrible financial crisis.

KAPLAN

10:25:34
The place where there was -- you know, obviously, people overleveraged was in the mortgage market, the regulated market rather than the private equity market. And one last point about the dividend recaps, that's a very confusing issue because Eileen seems to think we put leverage on the company, and then banks and investors just give the company more debt. And they don't think about whether they're going to get repaid. And that assumes that those investors are not thinking clearly. And what actually happens is private equity firms invest in a company, and it does really well.

KAPLAN

10:26:17
And when it does really well, they go back to the banks and say, look, we are doing really well. We'd like to take some money out. And the banks look at the company. And only if they think the company is doing very well do they actually let the private equity firms borrow more.

REHM

10:26:34
Okay.

KAPLAN

10:26:35
And, of course, when you borrow more, sometimes you have bad outcomes.

REHM

10:26:38
All right. Steve, I want to go back to that 7 percent. Is it true that that is double the number of bankruptcies that occur with publicly traded funds?

KAPLAN

10:26:56
It might very well be.

REHM

10:26:57
All right. I just want to clarify on that. Megan, I know you want to add.

MCARDLE

10:27:03
You know, I think there's always the question of, how do you measure the performance of these companies? How long should I look at it? And this was something that, when, you know, The Wall Street Journal investigated Mitt Romney's record, you saw is what's the proper timeframe. And also, you know, companies that go in to private equity aren't necessarily the same as companies that don't. They may have all sorts of different characteristics.

MCARDLE

10:27:26
And so there's always this question no matter how carefully the study is done -- and I've no question that the study was very carefully done -- that you have some sort of unobserved difference between these companies and the companies that are still publicly traded, which will make them more -- because, you know, frankly, you tend to go into a turnaround situation when a company is underperforming its peers.

REHM

10:27:49
Steve Kaplan, what do you think of the attacks on Mitt Romney?

KAPLAN

10:27:55
I think the attacks on Mitt Romney from his Republican counterparts are outrageous. He...

REHM

10:28:01
Eileen Appelbaum, what do you think of the attacks?

APPELBAUM

10:28:04
I think it's not possible to judge individual companies. My concern is not with Mitt Romney or his particular company, but with our having a better understanding of a relatively new phenomena. These private equity companies or the leverage buyouts have only been around since around 1980. They've become really popular since around 2000. And I think it's important that we understand what they are, how they operate and think about what we -- how we want them to participate in our economy.

REHM

10:28:36
Steve Kaplan mentioned that they pay income of -- on capital gains rates. What do you think about that?

APPELBAUM

10:28:47
Yes. I think that that sets up all kinds of incentives that don't make any sense. These are basically performance-based pay. If you do well, if the investments pay off, then you receive this pay. I don't think it's any different than the bonuses that CEOs of other kinds of companies receive, and I think it should be treated in the same way by the tax code.

REHM

10:29:09
Megan.

MCARDLE

10:29:10
Well, I think there's -- this is a really tough question. The tax code -- people tend to think that there's some sort of ideal tax code that you can get to. But the fact is you're always making tradeoffs. On the one hand, it's true that this is their job. On the other hand, you could argue that I manage my investment portfolio in my part time and that my capital gains tax is performance-based pay. And so you -- I think you sort of have to step back and not say, is there some fundamental justice question here, but is this setting up the right incentives that are sort of creating more economic value?

REHM

10:29:41
And, Steve Kaplan, how can you measure whether net jobs are actually created or not?

KAPLAN

10:29:50
So there's a very nice paper written by one of my colleagues, Steve Davis, and a number of other co-authors. And they got census data, so very detailed census data from the U.S. Census on employment, and they looked at how it changed after buyouts. So what was nice about that is they have as many buyouts as you can possibly find, and the data are as good as you can find. They're not perfect, but they're the best there is.

KAPLAN

10:30:19
And what they discover is that in private equity-funded companies in the three years after the buyout, employment at existing establishments goes down by about 3 percent relative to other firms in the industry, so most of the industries are growing. So employment is going up. It's going up 3 percent less in the private equity-funded companies. However, at the same time, they find that in new establishments, new operations that these companies are opening, employment goes up by more than 2 percent relative to other companies in the industry.

KAPLAN

10:31:00
And they conclude the net effect is close to zero, and there doesn't seem to be, you know, a strong effect one way or another overall. And what they also conclude is that it's consistent with creative destruction in the sense that you take an under-managed business, as Megan has said, and you cut out what is not working, and then you invest in what is working. And, actually, I got an email from one of my students yesterday who said that in his firm -- his firm does a lot of work for private equity firms.

KAPLAN

10:31:35
And what he actually sees is an expansion in head count and significant investment in expansion of the business, particularly in sales and marketing, and very consistent with what the large sample evidence says.

REHM

10:31:48
And, Eileen, you have problems with the study on private equity and employment.

APPELBAUM

10:31:52
I just really -- I would just like to talk -- I don't have problems with the study. The study is very good. I want to talk about what's in the study. In response to something that Megan said earlier, one of the interesting things is they look at employment growth in the companies that private equity takes over before it takes over it. And employment growth in those companies, on average, is the same as in the companies they don't take over.

APPELBAUM

10:32:16
So while you can have examples of private equity that has taken over a distressed company. On average, that's not what's happening. These companies were as good as the other companies, at least on employment grounds before they were taken over. After they're taken over, job creation is about the same in private equity-owned companies and other companies, but job destruction is much greater in the private equity-owned companies.

APPELBAUM

10:32:40
The way you get to that 1 percent is that not just looking at job creation and job destruction in the companies that private equity owns because if you look at that, in retail, for example, in this very study, they show 12 percent -- a 12 percent disadvantage in terms of employment growth for the private equity-owned companies. Retail is the worst performing sector in terms of employment.

APPELBAUM

10:33:03
But what they do is when they take over smaller companies -- privately owned companies that are now bought by private equity, they're smaller -- they grow those companies by acquiring other companies. They acquire the other companies, and they acquire the other companies' workers. So at the end of the day, more people are employed by private equity, but it's not that private equity created those jobs. Those jobs were already there. They're now in private equity companies.

KAPLAN

10:33:31
I'm not so sure that's the right interpretation of that paper, and that's not the interpretation I think Steve Davis and Josh Lerner...

APPELBAUM

10:33:38
I direct you to table seven, column two.

KAPLAN

10:33:39
...would give you. But let me add one thing that Megan -- that Eileen has been saying. She's been pointing to retail, and retail is really interesting 'cause there -- that's where the job losses have been concentrated. I think if you take out retail, you would -- you'd find, actually, job increases on average. And think about what's happened in the last 30 years in retail. We've had Wal-Mart, and we've had Amazon.

KAPLAN

10:34:06
And that has put a lot of pressure on retailers everywhere. And it seems to me that, actually, the right thing for many retailers to do over this period has been to contract. And it's sort of like arguing that retailers shouldn't lose jobs in a period where Wal-Mart and Amazon are ascendant, is that nobody should ever lose their job. That's something that, you know, they tried in the Soviet Union. It didn't really work.

REHM

10:34:34
All right.

APPELBAUM

10:34:34
I don't really think that's a fair comment.

REHM

10:34:36
OK. And you're listening to "The Diane Rehm Show." Megan, The Wall Street Journal, Steve Forbes, other people, say that Mitt Romney should answer some of the questions being asked about Bain Capital. I mean, for example, the claim that Bain Capital created at least 100,000 jobs, how do you look at that?

MCARDLE

10:35:06
I'm not even sure that he could come up with an exact number if he wanted to. And it goes back to what I said earlier, which is that what period do you measure over? Did you set up -- did you kill a product line that eventually killed the company? Or did you create a new project line that, 10 years later, was the company's main growth engine and created a zillion jobs? And so it's hard to -- there's no -- not going to be any actual figures.

MCARDLE

10:35:30
That said, I think Mitt Romney kind of opened himself up to this in the same way that John Kerry arguably opened himself up to attacks on his military service because he made that a centerpiece of his campaign. And Mitt Romney has made a centerpiece of his campaign, I am a businessman. I know how all the levers and the bells and the whistles and the economy work. And I can pull all the levers just right to make the economy start growing again.

MCARDLE

10:35:54
And when you say that, when you make those claims, people are going to come in and ask you to tell them about your record managing companies, what you did in the economy in order to say, you know, to find out how is this going to translate into the presidency.

REHM

10:36:10
And, Eileen, basically, you'd like to see the rules, and especially the tax code, changed in regard to these equity firms.

APPELBAUM

10:36:19
The tax code and also limits on the amount of leverage that they can place on these companies that they buy. I think they -- I think with the amounts of leverage that are currently being put on companies, what we see is that we are really putting them -- we're putting them at risk. We're also making it very difficult for them to be innovative.

REHM

10:36:37
Is there a limit on the percentage of leverage?

APPELBAUM

10:36:41
Not at the moment.

REHM

10:36:42
And you believe there should be.

APPELBAUM

10:36:44
I think we have to think about what would be reasonable limits, yes.

REHM

10:36:47
Steve Kaplan.

KAPLAN

10:36:49
Well, the limit comes from the banks who are in the business of making money. And I think Eileen should be relatively happy that those leverage levels have come down substantially over time, as I mentioned earlier, because the banks realized there is risk, and we want to get paid back. So I would just go back to the financial crisis when there was a lot of leverage buyout activity.

KAPLAN

10:37:17
A lot of people said that there were going to be a lot of bankruptcies. And we went through the financial crisis, and there were actually very few because what happened is the market worked without regulation. And I would -- I think it's working very well.

REHM

10:37:35
Steven Kaplan of the University of Chicago Booth School of Business. When we come back, your emails, your phone calls. I look forward to hearing from you.

REHM

10:40:04
And we're back with our first email from Ted, who says, "Most private equity firms go after businesses with good pension funds. They then shut down the firm because high debt leads to bankruptcy, during which the employees lose their pensions. This is the real problem." Megan.

MCARDLE

10:40:30
Well, I think that there is a question about -- pension funds are -- functionally, they're unsecured in bankruptcy. You can't take assets out of the fund. There's no way to strip a pension fund. But what you can do is if you have an underfunded pension and the company ends up declaring bankruptcy 'cause it bloated it down with debt, that pension fund is going to end up going to the Pension Benefit Guarantee Corp., which is a government insurer.

MCARDLE

10:40:55
And people are probably going to get lower payouts than they otherwise would have. And so that has led some people to say, well, what you're doing is functionally transferring money from the pension holders to the private equity investors. That's said, I don't know how common this is. There's a lot of urban legends about this happening all the time. But the bankruptcy rate, A, isn't so high, but also private -- defined benefit pensions are no longer so common that I think you can say this is the defining characteristic of private equity.

REHM

10:41:30
All right. Let's open the phones. We'll go to Fort Worth, Texas. Jerry, you're on the air.

JERRY

10:41:37
Good morning. How are you, Diane?

REHM

10:41:39
I'm fine. Thank you, sir. Good to have you.

JERRY

10:41:42
I use to be the president of the Ben Hogan Golf Company here in Fort Worth, Texas, and we were rated by one of these wonderful corporate raters that they're talking about creating jobs in our country. And guess what? There isn't one employee left working in that factory, and it no longer exists.

REHM

10:42:05
Steve Kaplan, do you want to comment or ask a question?

KAPLAN

10:42:09
Well, I would like to know who the investor was.

JERRY

10:42:14
Irwin Jacobs out of Minneapolis, Minn.

KAPLAN

10:42:18
OK. So Irwin Jacobs is a rater. He would not be one of the private equity firms that we're talking about here. I also want to say something about the previous question. Private equity firms, in order to make money, have to increase the value of the company, and the best way to do that is by growing it or reducing cost. And so take -- putting a company in bankruptcy is the worst possible outcome, and as we've been saying, there haven't been so many of those outcomes. And I think Megan got that right.

KAPLAN

10:42:46
Rating the pension fund is just not something that happens very frequently at all, and the reason is you want to make these companies better. And in fact, the private equity firms, not the Irwin Jacobs but the Dean Capitals, the KKRs, the TPGs, the Carlyles, invest a lot of resources in thinking about ways to make companies grow and also to make companies more productive.

REHM

10:43:26
All right. To Miami, Fla. Good morning, Bob. You're on the air.

BOB

10:43:31
Good morning, Diane, excellent show. I think a very thorough analysis of what capital means in America. I think our country was built on capital and continues to be built on capital. As a banker, I see, every day, people that aren't taught to borrow, that have no capacity for growth, that have no ability to grow their companies. And so they do seek out other investors at a time when they need them.

BOB

10:43:59
And often times, difficult decisions have to be made by others that the company or the management or the shareholders of the company were unable to do. And my question really has to do with responsibility. And the responsibility I'm talking about is the responsibility of the actual shareholders of the company in allowing the paying capitals of the world to assist them. There is profit motive. There is a greed motive. And I don't think that's being talked about.

BOB

10:44:31
I think what we're doing, or at least in the snippets of what I've heard in the news, is we're demonizing the ability to raise capital on this country by companies that have done it very, very successfully.

REHM

10:44:44
Megan.

MCARDLE

10:44:45
Well, I think one thing that the caller is right about is that private equity, in a lot of ways, is a response to the breakdown of the shareholder system of the supervision of management. And, you know, there's always a tendency to think that whatever policy problem we don't have right now is a much better problem to have than the one we do. And when you look at the companies of the '60s and '70s, they, quite often, really were private fifth terms run for the benefit of managers who were incredibly insuranced.

MCARDLE

10:45:14
The shareholders couldn't or wouldn't do much about it. The boards were fairly passive in the face of these managers who've been running companies for their own benefit rather than the owners. And so I think in some ways, the reads of the '80s that became so famous were perhaps an overreaction to that quite real problem, and I think that you still, actually.

APPELBAUM

10:45:37
You look at boards and shareholder oversight, and I think that it still leaves a lot to be desired and that, in some ways, private equity is filling that space. I think Eileen would probably say not necessarily billing it very well, but that it's filling a real hole in the kind of capitalistic system.

REHM

10:45:54
Eileen.

APPELBAUM

10:45:55
Yeah. I don't really disagree that private equity is filling a real hole in the capitalist system. That's -- I'm not advocating that we get rid of it. I'm just asking how we want to manage it. But back to the question of the '60s and the '70s and the '80s and the companies that are taken over, it's a very interesting question as to what they were managing these companies -- in what interest they were managing because one of the things that you had -- companies today want to be treated as if corporations are people.

APPELBAUM

10:46:23
But if you go back to that period, you actually had corporations that thought they belong to a community, who felt a responsibility to the arts in their local community, for example, or to the local high school to help build a field, who might have a fund that they use for community development, that understood the importance of having good relationships with their workers, might pay what economists call efficiency wages, a little bit more than you can get elsewhere in order to encourage higher effort and productivity.

APPELBAUM

10:46:51
They might use some of their funds for investment and innovation. Some of which would work out. Some of which would not work out. These managers -- they made their money only if the company survived. Their pay and pension and so on rose with the success of the company. They had a time horizon. If you think about Ford or you think about even Jack Welch or GE, they had a time horizon for those companies that was not three years or five years or even 10 years but was for the future.

APPELBAUM

10:47:21
They were building for the future. And to do that, you have to have a certain level of trust. There are implicit contracts in how you operate. Not everything is written down for retail. It's the relationship with the vendors. You place an order. They don't get paid until after you receive the order. If you don't pay them, et cetera, et cetera. So when these raters came along, when private equity comes along now, they don't have respect for that. They say, we need to monitor these managers. All of that money should be coming back to the shareholders.

REHM

10:47:54
All right. Let's go to Portland, Ore. Good morning, Les.

LES

10:47:59
Good morning. First thing I'd like to say is hello to Professor Kaplan. I had him in 1989 at GSP. When I...

KAPLAN

10:48:06
Hello.

LES

10:48:08
Hello, sir, excellent teacher. My experience is a little different. I work for a paper company. And in the 2000s, our facility was going to be divested. The WARN Act had already been filed, so we (unintelligible) shut down. And we were assisted or purchased by a company called KPS, which is a private equity firm out of New York, and they actually invested in the company, pretty much hands-off management as long as we performed, and actually got the facility got another 10 years of operation before, eventually, it had a shutdown due to changes in the paper industry.

LES

10:48:47
So for us, it was a positive experience. They maintained the union, and they created an environment where we could continue.

MCARDLE

10:48:57
Yes, I agree. That is the positive story, and it's the reason that I would never say that there's not a role for private equity. There's definitely a role for them in the economy.

REHM

10:49:05
Here's another experience from Sharon in Dover, N.H. Good morning, Sharon.

SHARON

10:49:13
Hi, Diane. I love your show.

REHM

10:49:14
Thanks.

SHARON

10:49:16
I just want to say it's not just in retail that this is happening. I've been working in call centers, customer service for, like, cellphone for years. And in the 1990s, a private equity firm took over a big call center on the North Shore of Boston that I was working at. And, within a year, that whole call center was shut down, everyone laid off, and the whole call center was moved to DeLand, Fla., where they could get customer service reps for very low wage, minimum wage. And that's what these equity firms are doing.

SHARON

10:49:51
They're coming in and finding, you know, areas of the country where they can get people for less and just shutting down. We -- everyone was laid off, and people hade been at that company for 20 years.

REHM

10:50:03
Megan, how unusual is that?

MCARDLE

10:50:06
Well, I think that it certainly happens. And this is part of cost cutting. I mean, this is part of how you go in and make a company more valuable. If they're paying higher wages than their competitor in the industry, often you find ways to cut those wages, whether it is laying off employees so that the wage bill goes down or moving it to a lower-wage area.

REHM

10:50:26
But...

KAPLAN

10:50:27
And I...

REHM

10:50:28
...does that mean capitalism has no heart? I mean, I realize that that sounds like a pretty silly question.

KAPLAN

10:50:38
Here's -- can I take that one?

REHM

10:50:39
But you got people in need of jobs. You've got capital investors who are only interested in how much money they can make. What happens to the people of this country, Eileen?

APPELBAUM

10:50:59
Well, this is a serious concern. This is the creative destruction that Steve was talking about before. So you destroy the jobs here and you create them there. It's not clear...

REHM

10:51:10
At lower wage.

APPELBAUM

10:51:11
At a lower wage. That's right. It's not clear how we're going to have a middle-class economy in this country if we continue down this path. And it's not just private equity. We shouldn't -- they're not different than other people in this country. Manufacturing has begun to come back to this country on a two-tier basis, for example. Companies bring manufacturing back, but they open a separate factory with a separate wage rate. We have to really ask ourselves what is an economy for and what kind of country do we want to live in.

REHM

10:51:38
All right. To...

KAPLAN

10:51:39
Can I...

REHM

10:51:40
Sure.

KAPLAN

10:51:40
This is a tricky -- I'd like to weigh in. This is a very tricky time because you have this immense technological change and globalization. And I would say, over the last 15 years, you've seen a huge amount of innovation. You've actually seen terrific productivity growth in the United States, but part of that has been because of technology and globalization, which puts real pressure on some workers including the caller.

KAPLAN

10:52:05
And the question is, how do you adjust? In a free enterprise system, you adjust and it -- you lost some jobs, but you created others. I think the alternative is to turn into Western Europe, where you can't make those adjustments. And I think that ends up hurting everyone rather than making the adjustment, having a free enterprise system and having growth.

APPELBAUM

10:52:24
Well, actually they do make the adjustment in Western Europe. The way the Germans do it, for example, is that they reallocate labor. They cut back on hours if they have to. They have been very successful in this recession in adjusting their labor supply to the lower demand, much more than we have and much lower employment rate than we have. So that's not really a fair comparison.

KAPLAN

10:52:44
Germany is a good example. They're more like us. France, Italy and Spain, much less.

REHM

10:52:48
Megan.

MCARDLE

10:52:49
Well, I think that there's actually two questions embedded here. The first is, do we want to move call centers? The second question is, do we -- because at any given time, any real productivity-enhancing improvement is going to put someone out of work, and it's going to be really hard on that person. That is not a blithe -- it's really terrible to be someone who operated a machine where they don't need the operator anymore.

MCARDLE

10:53:09
The question is how do you then transition those people, if that happens? How do you up-skill those people? How do you -- and that's a public policy question, not a public -- private equity question.

REHM

10:53:16
And that's what (unintelligible) you know, has been talked about for years and years.

MCARDLE

10:53:19
Yes.

REHM

10:53:19
How do retrain? We are terrible at retraining. And you're listening to "The Diane Rehm Show." To John in Indianapolis. Good morning to you.

JOHN

10:53:34
Good morning, Diane. How are you this morning?

REHM

10:53:35
I'm good. Thank you, sir.

JOHN

10:53:37
I just wanted to give you a brief update on my own experiences to this process. I am a president and CEO of a small technology company in Indianapolis. I cycled through venture capital. We are a technical engineering-based organization. There's a number of things you have to take into account when you go through these operations. I told the -- your gentleman that we had a neutral experience. It was neither positive nor negative. But there's a lot of education that needs to be done prior to jumping into these kinds of situations.

JOHN

10:54:08
As an example, a venture firm, if only offering you 30 percent of the purchased equity, will take virtual control of your company. This is the number one thing that happens. You don't have control anymore of the cash flow that organization does. So if you're willing to take on those kinds of accepted conditions, this is one of the things that take place. Talking about what the future holds, my company goes through many changes in terms of products. We've had one layoff in 26 years. It was a number of years ago.

JOHN

10:54:42
What we tend to do is we tend to just focus on our core capabilities. And for our people that no longer are needed in one segment of the business, we look for other businesses that can be -- create opportunity, create applications for new products that we could be developing. So we continuously develop a strain of new processes and new materials and new operations to continue to keep those people active. We've had job growth all along. This is the way it really works successfully, I think is the better way to put it. We don't have a two-tiered wage structure.

JOHN

10:55:17
We are not union, by the way. It's not because I chose not to be. It's just because there's not been a need to do so.

REHM

10:55:25
How interesting, Eileen.

APPELBAUM

10:55:26
Well, that sounds like a great, great company and a fabulous story. And that kind of internal flexibility, as opposed to lay these workers off and go try to find some new college grad who has the skills you already need and never bother to train your workers, I mean, I really applaud what you're doing. I wish more companies were doing it.

REHM

10:55:46
And, Steve, last word from you on this kind of approach.

KAPLAN

10:55:54
He -- it's what I teach in my course is what to expect. So I wish you had -- I wish I'd had you in my course. You know, the example he gives, I think, is correct. In certain situations, the -- or in general, the venture capital investments are going to have a lot to say in how the company runs. And in many cases, that's a good thing, but not always.

REHM

10:56:20
And here's a final email from Philip, who says, "I'd be satisfied with Mitt Romney's public announcements on the subject of his work with Bain Capital if he were merely to defend the role of the firm in both rescuing and liquidating companies and honestly acknowledge that nothing in that process illuminates the process of enterprise formation or drug creation.

REHM

10:56:55
Want to thank you all so much for joining us, Steven Kaplan of the University of Chicago Booth School of Business, Megan McArdle, senior editor of the Atlantic, and Eileen Appelbaum of the Center for Economic and Policy Research. Thanks for listening, all. I'm Diane Rehm.

ANNOUNCER

10:57:21
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